How Safe Are U.S. Bonds?

There is a pervasive notion out there in the investing world that U.S. government debt (be they notes, bills or bonds) is one of, if not the safest instruments out there for investors. There is no such thing as a free lunch though, and investors need to take a broader view of risk when evaluating this topic. While U.S. government securities are indeed some of the safest investments available by certain measures, they are by no means a risk-free investment option.

The Faulty, but Convenient, Premise of "Risk-Free Return"Part of what bulwarks the idea that government securities are risk-free is that financial models seem to say that they are. After all, concepts and models like modern portfolio theory, Black-Scholes, and the capital asset pricing model all require a "risk-free" rate of return in the calculations. While alternatives like German bond rates and Euribor rates have been used from time to time, U.S. government securities often fill the role as a proxy for that risk-free rate.

Why is this? Well, academics believe that there is essentially zero default risk to U.S. government debt and that short-term securities like Treasury bills have little interest rate risk because of their short duration. Insofar as it serves the needs of these models, then U.S. government debt is indeed arguably the closest thing to a risk-free instrument that is out there. (For related reading, see Get Acquainted With Bond Price/Yield Duo.)

Deconstructing the RisksJust because something works reasonably well in a model, it does not automatically follow that it is absolutely true, or true in all real-life situations. Accordingly, there are factors that make U.S. bonds definitely something other than risk-free for investors.

Default RiskAnyone who has watched TV or picked up a newspaper in the past few months has heard of the furor over the U.S. debt limit and the risk that the U.S. government would default on its financial obligations. While U.S. debt instruments typically enjoy a presumption of absolutely security, that view has been severely shaken of late - not only because of the wrangling in Congress, but also due to the turbulence in Europe and the increasing realization that the U.S. cannot indefinitely support sizable deficits, high debt, and low inflation/interest rates simultaneously.

In practice, this is not a risk that should bother the average investor. Simply put, people who buy U.S. Treasury instruments will get their money back.

Rate and Reinvestment RiskJust because an investor will get his or her money back, that does not mean that the investor will get the expected value back. An investor can buy a 30-year bond and hold it to maturity, but if rates (and inflation) have increased significantly over that time, the purchasing value of that principal will be much lower than the investor may have anticipated. The statutory value of that investment hasn't changed (a $10,000 bond is still $10,000), but the real world value of that $10,000 could have changed substantially.

Along similar lines, U.S. Treasury securities do carry meaningful reinvestment risk. It is entirely valid for an investor to buy a certain amount of Treasurys with the idea of using the interest to cover living expenses. While the purchasing power of that interest may erode over the years, that nominal money flow is almost certain to be safe. A problem can emerge when those bonds mature and it's time to roll over the principal into new instruments. If rates have fallen, investors may find that they have to significantly reallocate their investments to earn a similar cash flow. Likewise, inflation may have eroded buying power over the years to the point where available rates do not adequately cover their expenses. (For related reading, see 6 Biggest Bond Risks.)

Market riskIn actual practice, not many investors own individual Treasury securities. It is much more common for investors to own shares of fixed income ETFs or mutual funds. Here too though, there are risks even in those funds that devote their assets to "safe" Treasurys.

As interest rates move up and down, and as investor perceptions of default risk change, bond prices move as well. If a fund manager makes the wrong moves, buying with the expectation of higher rates and instead seeing rates fall, that manager is going to underperform. There is much less risk of a total wipeout than in equities (unless the manager/fund employs leverage), but the spread between Treasury returns and inflation is so small that it only takes a little bit of underperformance to lead to losses in real money terms.

The Bottom LineTreasury securities or U.S. bonds are not risk-free securities. It is true that the risk of the government stiffing bondholders and refusing (or being rendered unable) to pay is minimal. The reality is that if the government chooses to use inflation to reduce the value of its obligations, investors will find that the value of their bonds is much less than they expected. Likewise, if investor expectations of interest rates, inflation, and relative credit risk prove to be wrong, the value of a portfolio of bonds can end up being much different than originally expected at the time of purchase.

Simply put, there are no free lunches out there. Cash may have the least amount of default risk, but the steady march of inflation means anyone holding cash is certain to see a loss in real value terms. With U.S. bonds, the risks are different (a little more default risk for instance), but still present. U.S. Treasury securities may well still be some of the safest options available to most investors, but they are not risk-free and investors would do well to not only research those risks, but look to offset them with diversification. (For related reading, see The Risks Of Sovereign Bonds.)